The Allowance for Doubtful Accounts is used when Bad Debt Expense is recorded prior to knowing the specific accounts receivable that will be uncollectible. For example, a company might have 500 customers purchasing on credit and they owe the company a total of $1,000,000. The $1,000,000 is reported on the company's balance sheet as accounts receivable.
The company doesn't know specifically which customer will not pay, but it estimates that a few customers out of the 500 will not be paying the full amount they owe. The company estimates that $10,000 will not be collected. Rather than waiting until those specific customers are identified, the company makes an accounting entry that debits Bad Debt Expense and credits Allowance for Doubtful Accounts.
The amount of the entry will be the amount necessary to get the ending balance in the Allowance account to be a credit of $10,000. When the balance sheet is prepared, it will show Accounts Receivable of $1,000,000 less the Allowance of $10,000 for a net realizable value of $990,000—the amount that will likely be turned into cash.
The entry also meant that the income statement will be reporting $10,000 of Bad Debt Expense sooner than if the company waited for the customers to admit they were not able to pay. This means that the expense is matched more closely with the revenues—the goal of accounting's matching principle.
While this allowance method is good for financial reporting, it might not be allowed for income tax purposes. Be sure to check with a tax professional for the income tax rules.
